The financial press these days is replete with experts marveling at the US economic miracle of high growth with no inflation. Rather than being an economic miracle, however, it is just simple economics. The huge growth in debt over recent years has provided a veritable flood of money that has lifted stock and real estate prices not only well above their historical norms, but well above all previously recorded peaks. The ready availability of money, capital gains on investments and confidence that the good times will continue indefinitely has led many Americans to spend more than they earn. Sustained strength in consumer spending has, in turn, fueled the robust GDP growth rates. In parallel with this unprecedented expansion of credit within the US, many of the major exporting countries of the world have suffered economic slow-downs. These countries have attempted to rejuvenate their economies by selling as much as possible into the huge and seemingly insatiable US consumer market, devaluing their currencies along the way in order to maximise their price advantage. The deluge of cheap imports has held US consumer prices in check despite the huge growth in money supply. So there you have it – strong economic growth with no (as measured by the CPI) inflation.

It should be noted that a high money supply growth rate is not a pre-requisite for strong economic growth. In the days of sound money, that is, in the days when money could not be created and destroyed at the whim of banks and governments, strong economic growth was often accompanied by no inflation. Modern money, however, is not simply a mechanism that is used to make economic transactions more efficient – it has its own direct influence on the economy. Nowadays, as the people of a nation become more indebted, the supply of money increases. As long as the confidence of both debtors and creditors can be maintained at a high level then the amount of debt can continue to expand. A virtuous cycle is created, with increased debt (money) fueling higher asset prices, consumer spending and nominal GDP growth which, in turn, lifts confidence and encourages the accumulation of still more debt. It is the absurd nature of modern fiat currency whereby the more indebted a nation becomes, the more prosperous it will appear to be – temporarily. And, if the currency of the indebted nation is in demand throughout the rest of the world, then 'temporarily' can be a long time.

The most obvious symbol of America's love affair with debt is the US stock market. The bull market in equities almost died during 1998, but was resurrected by the greatest monetary injection in the history of the United States. The speed with which confidence was shattered and then restored between August and October last year demonstrated both the fragility of the financial system's support structure and the lengths to which the authorities were prepared to go to avoid a credit contraction. From the depths of despair a new phase in the bull market was born, credit began to expand at an even greater pace than before and investors became more complacent than ever.

Having risen in an almost straight line since the low point of early October 1998, a new risk is now emerging for the equity bull market. This risk is a subtle and almost inexplicable decline in the US Dollar. I describe the decline as almost inexplicable because it is happening in parallel with quite aggressive attempts by the central banks of Japan, Britain and Europe to devalue their respective currencies against the Dollar. In normal circumstances, currency devaluation is something governments can do extremely well. The fact that the devaluation efforts of these governments are currently falling flat may indicate a growing imbalance in Dollar supply/demand. A continuation of the Dollar's recent frailty, which probably stems from the combination of a $20B per month trade deficit and signs of economic recovery in both Japan and Europe (leading to capital repatriation), has the potential to create havoc in the US financial markets.

Since mid 1995, strong investment demand for US assets has led to a strong Dollar and has helped support asset prices. The potential to gain from both an increase in the Dollar exchange rate and an increase in asset prices has stimulated further investment demand (nothing encourages investment more effectively than a rising market), and so on. The opposite (but so far not equal) reactions to these forces are the growing trade and current account deficits. Benefits accrue from the trade deficit because the US is able to provide notes that can be created without limit (US Dollars) in exchange for valuable goods and services. The willingness of foreigners to accumulate these notes for investment purposes enables real US interest rates to be kept at low levels (a rise in interest rates is usually the penalty for running consistently high deficits). However, the deficits increase the supply of Dollars in foreign hands and a point will eventually be reached when the burgeoning supply requires either lower prices (exchange rates) or higher investment returns (interest rates).

Unless there is an external crisis that causes capital flight to the US, the strong foreign demand for US Dollars (so critical to the US financial markets and therefore to the US economy) may not be sustainable in the absence of higher US interest rates. This provides a quandary for the Fed. On the one hand higher interest rates would be anathema to a stock market priced for perfection. On the other hand allowing the Dollar to weaken would not only result in an acceleration of capital repatriation, but would also lead to a series of follow-on currency devaluations throughout most of the world.

The defense of the strong Dollar will most likely be the path chosen by the US monetary authorities, for two reasons. Firstly, a weakening Dollar does not only have the capacity to end the bull market in US equities, it also has the potential to derail the fragile economic recoveries taking place in Europe and Japan. Secondly, Greenspan appears to believe, based on recent testimony, that the Fed can use monetary policy to moderate the effects of a bursting bubble should the stock market over-react to another increase in interest rates.

As long as the demand for US Dollars outside the US and the level of confidence inside the US can be maintained at high levels, the US stock market is unlikely to suffer a prolonged and steep (> 30%) correction. However, if either of these props should falter, the current over-valuation of the market would guarantee a sharp fall in stock prices.

During the past few years stock market bears have been quick to label every 5% decline in the Dow as the beginning of the next great bear market. At this time a correction has most likely commenced that could potentially be quite 'gut-wrenching', particularly if it is exacerbated by Y2K fears over the coming few months. However, I do not believe we will see the end of the equity bull market in 1999 for the following three reasons:

• Firstly, I would expect to see a sustained decline in the US Dollar prior to a final top being formed. A falling Dollar would indicate weakening foreign demand for US debt and equities, relative to the increasing supply of Dollars resulting from the trade deficit, removing one of the market's props. It is too early to tell whether or not the current mini-flop in the Dollar, as discussed above, is the beginning of a new trend. In any case it would need to persist for several months to be of 'bull market ending' significance.
  
  
• Secondly, the gradual erosion of confidence in financial assets that precedes the completion of the bull market should be indicated by a rally in the gold price. Distribution will occur for some time prior to the bull market's finale as the most astute (and often the most wealthy) investors prepare themselves for the end of the current cycle. Such distribution is never noticed by the mainstream press or the general public. In fact, the economic environment will appear so rosy at the final top that the public will be buying more aggressively than ever (if they didn't there could be no top and no distribution). However, a rising gold price over several months leading up to the top will signal a stealthy shift of investment from financial to physical assets by those who can see beyond the next earnings report and FOMC meeting.
  
  In a report posted at the end of May I wrote that the following factors, taken together, suggested that a gold bull market was about to commence:
  
  
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  - Extremely negative sentiment
  - The good performance of gold mining share prices compared to bullion prices
  - A surge in resource stock prices
  - A strong rally in oil prices
  - Indications that commodity prices had bottomed
  - Signs of inflation becoming more visible
  
  Although these bullish factors remain in place, gold has fallen to new 20 year lows indicating that it is still firmly entrenched in a bear market and that we are not yet witnessing the shift in investment demand described above.
  
  
• Thirdly, a final top to this incredible equity bull market should be characterised by the sort of rampant optimism that leads to a massive buying spree encompassing virtually all stocks. Right now the average stock is trading below the highs reached in April 1998. What we have actually seen during the past year is a rally in big-cap and tech stocks that has propelled the major indexes to new highs, but with minimal participation from small and mid cap stocks outside the technology group. The greatest of all bull markets is not likely to end on such a note.
  
  

The stock market 'permabears' only ever see the problems that will cause the next crash – negative savings rates, record current account deficits, high debt levels, rising interest rates and lofty valuations. The stock market 'permabulls' can't seem to look beyond the good company earnings reports, a low CPI and the great technological advances that are revolutionising business. Reality will probably end up somewhere between the two, with the bears feeling satisfied for the next few months before a new buying opportunity emerges.

Milhouse
Hong Kong
26 July 1999

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